Broomer's Blog

Outlook June 2018

Geopolitical events invariably cast a shadow over markets, but it is relatively rare for them to manifest into something that affects the economic cycle. Events that alter the secular trend are even more exceptional but this is not to say that they don't happen. Thatcher's deregulation drive of the 1980s and FDR's 'New Deal' are examples and we suspect that Trumponomics may be another. Labelling Trump's policies as Trumponomics is unhelpful since it hints of an underpinning philosophy, which is entirely absent. Political direction rests with a demagogue.

For decades, economies and markets have quietly benefited from freer movement of goods, capital and labour. This is a trend that has not only been halted but sent into reverse. The direct impact of $20bn of tariff costs on a $20tr economy will be trivial but adds unwelcome grit to the running of the system. It will be interesting to observe voters' reaction as the repercussions are felt. Already, mid-Western soybean growers are grumbling as soon might the blue collar shoppers of Walmart where 70-80% of goods are sourced from China.

This can't be good news for bonds but we view the growing disparity in yields between the UK and US with some interest. Gilts at a 1.3% yield have no attraction for us. Their value as an insurance policy is limited by the lack of any capital upside even in the most favourable environment. Not so with US Treasuries where yields near 3%. If recession strikes, a 15% upside in capital is conceivable. Treasuries offer too a carry uplift, though this would vanish once the currency is hedged as we would certainly want. We should look into whether this trade is available to us in the retail space before we seriously begin to weigh it versus the risks of further yield increases.

Markets have recovered from their wobbles of the first quarter and once again are flirting with new highs. The tax cut sugar rush is proving impossible to ignore as profits soar. US profits will head towards a 10% share of GDP, a peak and a long way from the typical 5-8% range experienced for much of the last 70 years. Reaganomics proved that tax cuts can be self funding (well in part anyway) but America Inc. is in a very different situation today. The impact will be similar to that of throwing lighter fuel on a well established fire. Later, when the fire dims the authorities will curse the flagrant waste of a limited propellent.

Brexit remains on its tortuous course. We are impressed with May's performance in holding together her Party despite the distinct lack of compromise offered by the EU so far. Come the end of the year, Brexiteers will be left with the uncomfortable truth that the EU cannot pander to some of their more fanciful ideals. A hard, stark Brexit or a half-baked 'vassal State' continuation seem to be the only options on the table. The right wing of the Tory Party will hate the latter almost as much as financial markets will detest the former. This could lead to a lively end of year for UK assets yet many UK managers are telling us that UK domestic stocks are now priced to discount the worst case scenario. This is interesting; a profit share always has value and if it's been given away... However, care must be taken to consider these valuations against the new business paradigm as opposed to the rather more generous business environment of the last 20-30 years. Many industries face problems that go way beyond Brexit, retailers for example.

Meanwhile, the pressure mounts on the Exchequer. After years of gentle austerity, the fat has been purged from the public sector yet a stubborn structural deficit remains. Squeals from the NHS have grown too loud to be ignored, the answer is an additional £20bn pa. May's parlous political position leaves her with few options. Other shouts such as the £12bn needed for road repairs will become increasingly loud. At least May has shown some mettle in challenging the military as to why the UK needs 'tier one' armed forces. It has been patently obvious for over 70 years that the UK is far from a tier one global power, yet the generals and admirals have taken the news like an elderly patriarch whose offspring have just broached the idea of a move to the old peoples home. Taxes will rise (possibly on the corporate sector) as will borrowing.

China faces Trump's frontal trade attack and markets have taken note. We wonder however if this is misplaced. Much negative sentiment surrounds Chinese stocks, principally surrounding debt and trade issues but we sense these threats may be behind us. While the depth of debt situation remains opaque, the authorities seem to have made impressive strides to address the issues. While the economy continues to grow, we believe that this is not an issue that will flare. The confrontation with Trump is unhelpful but in no way as dangerous to the economy as it might have been say 10 to 15 years ago. The economy is being successfully rebalanced away from exports and investment towards domestic consumption, principally private. The capital account is gradually being opened up and the MSCI's decision to include the A share market within the EM complex is meaningful. The initial move only lifts a point or two, a full move would bring exposure to 16%, lifting China's total share of the index to over 40%. This trend will bring a steady flow of index money into the market. The local markets rightly have a casino reputation and sentiment is often driven by excitable inexperienced retail investors. According to BlackRock, private investors still account for 55% of volumes though the share is declining. This should leave plenty of room for savvy professionals. On 13x forward earnings, this market does not appear to be expensive currently, and at a time when so many markets appear fully valued, begs closer inspection.